Advice from a top money manager about staying the course
While big tech stocks were last year’s stock market winners, the shares of companies whose fortunes are more tied to the economic cycle, such as industrials, financials and energy have been on the rise of late. As this “sector rotation” continues, we took the opportunity to speak with EdgePoint’s Tye Bousada, one of Canada’s top money managers and one of the independent global equities managers in Newport Private Wealth’s portfolios.
For the first nine months of 2020, EdgePoint’s “buying growth without paying for it” style of investing was out of favour, as investors seemed willing to pay any price for growth. But as the market shifted, EdgePoint’s performance has roared back, up 25% in the last six months.*
In this interview, Newport’s Chief Investment Officer Mark Kinney talks with Bousada about EdgePoint’s strategy, the prospects for their portfolio of companies; and why even a good business is a bad investment if you pay too much for it.
MK: When the pandemic hit and the market sold off last March, can you talk about how the EdgePoint Global Portfolio reacted and the changes you made to reflect the new realities?
TB: It comes back down to what we always say: volatility is the friend of the investor who knows the value of a business and it’s the enemy of the investor who doesn’t.
We saw extreme volatility over the last 12 months and we certainly took advantage of that volatility. On the buy side, we added 15 companies to the Global Portfolio. That is an enormous amount of new activity for us in a year.
To put it in perspective, our goal is to add 6 new investments every year. So, to find 15 is more than double the normal activity level that we’d have for the portfolio.
We’re pleased with the decisions we’ve made thus far on the buy side.
MK: Were there any companies that were “broken” by the pandemic that prompted you to sell and move on?
TB: Going into the pandemic we had three businesses, totalling about 5%of the portfolio, that we saw as being poorly positioned in the face of COVID-19, and that we exited.
Let me give you a couple of examples to demonstrate how we determine our positions in extraordinary circumstances like Covid.
Aramark Corporation is one of the three largest global caterers in the world. About 15% of their business is catering sporting events globally.
In February 2020 we started to worry about what sporting events would look like, so we exited that position. It was the right thing to do; as we expected, the share price continued to decline materially. But we also continued to watch the business closely. About five months ago we re-entered it at right around the same price that we sold it for.
So why the reversal? Because despite the catering business being absolutely decimated, we looked at the total business, and we saw potential. Aramark also manages outsourced cafeterias, for institutions like hospitals and universities. As health concerns around Covid grew, institutions increasingly began to outsource their cafeteria operations.
Coupled with that, Aramark didn’t lose free cash flow in 2020, which is a phenomenal accomplishment. Our conclusion was that if they could manage through that type of situation, then they could manage any situation going forward.
Here’s one that wasn’t broken, but – had we been reacting emotionally – we might have let it go because of its shaky early performance in 2020.
Berry Global is a plastics producer that amongst other things makes liners for diapers, and the liners that go into PPE masks.
In 2020 Berry’s sales were up 24%. But – from the beginning of 2020 until the middle of March – the stock fell 45%. The mispricing didn’t last long and eventually the stock rebounded approximately 113% and finished up around 20% from where it started.
The lesson here is that dislocation happens all the time in the stock market and it’s generated by the fact that people often don’t understand the value of what they own. They let other people navigate their emotions for them by setting the prices of the companies that they own for them.
MK: I want to come back to managing emotions in a minute. But first, I want to ask you about what you call the “non-obvious” growth companies your team seeks out. Can you give us an example?
TB: Let’s talk about a company called O’Reilly Auto Parts that wasn’t obvious when we bought it in the second quarter of 2020.
O’Reilly does two things. They run do-it-yourself centers for people who fix their own cars; and they run distribution centres for auto body shops and jobbers to supply car parts fast.
When we looked at this business in spring of 2020, we had a couple of thoughts about why it was going to grow. The first was that early data showed that where COVID-19 was receding, in places like China, driving was spiking back up. People were choosing to drive instead of taking public transit.
Based on the initial data we saw out of China, we also saw a big growth turn from two places: more collisions and more wear and tear on vehicles. The collisions help the distribution centres, and the wear and tear benefits the do-it-yourself centres.
O’Reilly not only grew organically into a market that was also growing organically – they took share from their competitors. And we weren’t paying for that growth.
The share price has done very well, and they continue to ride the tailwinds of taking market share, especially when we consider that miles driven in North America are not back to where we were a year ago.
MK: Investors know the story of 2020: returns came from primarily a handful of big-tech stocks. Can you talk about why EdgePoint chose not to own these?
TB: It’s not that we didn’t own technology stocks last year. It’s that we didn’t own the obvious technology stocks. We own Fujitsu, for example, a Japanese business that’s classified as a technology business that did exceptionally well last year.
We’ve owned a lot of tech stocks in the past, including Microsoft, which we owned for three years and almost doubled people’s money on it. But we owned them when we weren’t being asked to pay for growth. Because if you overpay for growth, you’re not differentiating between a good business and a good investment.
When we looked at the past seven decades of data, what we saw in 2020 was the biggest spike in relative valuation of ‘big growers’ (think Amazon, Alphabet, Facebook, Visa, MasterCard, Nvidia, Netflix, Tesla etc.) vs. other large cap businesses. The big growers went over five times the price to earnings valuation compared to other large caps.
People got carried away and flocked to what made them feel comfortable. And what made them feel comfortable were the obvious growers.
Even though we’ve seen a material reversal this year we’re still at almost unprecedented levels. We believe that the peak that we had in 2020 – which surpassed the peak in 1999 – should be scary. It’s certainly scary to us.
Our job is compounding wealth over the long term. It’s in part finding companies that fit our investment approach, but at the same time also means not doing anything stupid.
And investing in growers that make you feel comfortable in the short term but where you don’t have a proprietary view, is something that we want to avoid at all costs.
MK: The trade-off was that the companies you own weren’t in favour for the first nine months of the year. But over the past six months the portfolio has done phenomenally well, up 25% – So how do you keep faith in your discipline through those times when you may lag?
TB: If we look at the last 50 years of data what you will see is that in every decade, investors made bets in line with the consensus. If you invested in the Nikkei in Japan in the 80s, emerging markets in the 90s, dot.com in 2000, or the housing market in 2006, you would have experienced permanent loss of capital.
What was your only mistake? Investing in line with consensus. That’s never been a good recipe for creating wealth.
It’s not what you don’t own that’s going to dictate your returns but it’s what you don’t own that makes people focus on the short term. That’s what happened in 2020 to us, but that’s not what dictates our long-term ability to compound money.
Our goal is not to look right every single quarter or every single year. It’s impossible to do that, and certainly impossible to compound wealth faster than the index by looking the same as the index.
In order to compound wealth materially over the long term, you have to be willing to look wrong in the short term.
Lastly, our goal is to have a portfolio that’s diversified by businesses away from obvious correlations and non-obvious correlations.
It should be clear to a lot of people that having 30% of the index invested in a couple of technology stocks is an obvious correlation, and that’s a risk we’re trying to diversify away from.
So, it’s not that we were making a singular bet on the economy recovering. What we’re trying to do is diversify the portfolio with a varied business mix, which is the exact opposite of what most people were doing last year – concentrating their bets in a very small slice of the economy that represented a large portion of the index.
MK: Any concerns about valuations and what another market pullback would mean for the businesses that you own?
TB: It’s very difficult for us to paint the market with a broad brush and say it’s overvalued, or it’s undervalued, because we don’t own the market. We own a very small collection of businesses around the world.
What I can promise you with 100% certainty is that the markets are going to continue to be volatile. So how do I approach investing with that knowledge?
As I said, volatility is a friend of the investor.
Let’s look at Tesla. About eight weeks ago Tesla was worth more than all the other automotive companies combined. And Tesla had about 1% market share, so if you own Tesla, it was going to have at least a 50% market share going forward because it had 50% of the value of all the automotive industry.
Is that a safe bet?
It’s unlikely that they’re going to have at least a 50% market share or have 50% of the entire profitability in the industry, five years from now. So how do you navigate as a portfolio manager in that market?
In comparison is a business that we’ve owned for a while called TE Connectivity (TE). It makes connectors that allow electricity or information to travel between two points. The largest end market is the automotive industry.
The most attractive thing about TE is their content on an electric vehicle (EV) is twice what it is on a gasoline-powered car. Combine that with the fact that every auto company has launched an EV and suddenly TE’s business is that much stronger. So, even if the same number of cars are sold every single year, TE has a tailwind of 5 or 6% annual growth.
If Tesla was going to take over the world it’s especially good for TE, but what EdgePoint is paying for is less than one 20th of the valuation of Tesla.
MK: We always take a long-term view and we know you do too. What time horizon would you say an investor should have to properly assess performance?
TB: Our goal has always been to do right by the end investor, to have performance that is superior over a 10-year time frame. You could get lucky over a year or two, but you can’t luck out a decade’s worth of performance.
MK: That’s exactly right. When people ask me, ‘what’s the best way to select a money manager?’ I tell them to pick a manager with a great long-term track record and a poor short-term record. Last question: an investor’s return is partly based on the money manager’s decision and partly based on the investor’s own behavior. Can you explain the difference?
TB: Think about top money manager Peter Lynch’s track record on the Fidelity Magellan Fund from 1977 to 1990. You can see Lynch did about 29% compound annually, which is phenomenal. But the average investor in the Magellan fund during that period actually lost money! **
How do you do that? You do that because you acted on the wrong time frame. The investor is buying it when the 1-, 3- and 5-year numbers look fantastic and they’re selling it when the 1-, 3- and 5-year numbers look crummy.
Why do investors do this? Because it’s very hard to manage their emotions.
They want to make investment decisions on how to get to a future financial goal based on how they feel today, but 100% of the time in history that’s proven to be the wrong decision.
People are terrible at managing their emotions when it comes to the stock market. And if you let other people navigate your emotions, you will never get to your financial goals.
That’s why it’s so important to work with companies and advisors who approach investing rationally and in a business-like manner and take the emotions out of it. And that’s why we appreciate our partnership with Newport. You’ve trusted us in good times and bad when we’ve looked wrong, and when we’ve been right. Our shared values make for sound decisions and solid results over time.
*Source: Bloomberg. As at March 23rd, 2021. Total returns, gross of fees in Canadian Dollars. Past performance is not a guarantee of future results.
** Source: Fidelity Investments, Matt Driscoll, “Discipline: A key to success in business and investing”. Tuve Investments, Inc., 2008
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